As prices slide from the peak, appraisers see cap rates widen between Class A properties and lower-quality assets
By Bendix Anderson
Because appraisers value deals and study markets in every part of the country, they can spot patterns and warning signs individual investors often can’t see. Their message today is sobering.
“People are paying these ridiculous prices,” says Tom Griffith, director of the seniors housing practice for Chicago-based Principle Valuation. “It’s a little hard to justify the highest prices based on comparable sales.”
The issues that concern top appraisers should worry everyone in the seniors housing business. As the market for properties inches back from its peak, top appraisers are observing overregulation, overbuilding and misguided optimism about the likely income from properties.
They say prices have already begun to weaken for Class B and C properties, and may soon begin to fall for Class A assets.
Clinging to the peak
Prices for the best seniors housing properties are quite high. The capitalization rates — the initial returns to investors based on purchase prices and net operating income — are still near the historic lows set a year ago for Class A properties.
“I’m a little surprised that cap rates for Class A properties have stayed as low as they have for as long as they have,” says Charles Bissell, executive director for Integra Realty Resources based in Richardson, Texas.
Prices have already started to fall for seniors housing properties overall, dropping to an average of $164,000 per unit in the third quarter, including independent living, assisted living and memory care. That’s down from $176,000 the year before, according to the National Investment Center for Seniors Housing & Care (NIC).
The average cap rate for seniors housing properties was 7.7 percent in third quarter of 2016, according to NIC, once again including independent living, assisted living and memory care. That’s up from 7 percent a year ago.
“Class A assets are still highly sought after and will generate multiple offers,” says Zach Bowyer, managing director for CBRE Valuation & Advisory Services based in Boston. “Less attractive assets sit a little longer.”
Challenges mount
It’s a difficult job to appraise a property at the top of a real estate market. Knowing which direction trends like cap rates are headed can be challenging — especially when Class A and Class B properties begin to move in different directions.
“It’s more challenging to appraise properties when you have a significant shift in values,” says Bissell.
Sales of comparable properties are often not enough to show where the market stands today for a particular seniors housing asset because the most recent sale of a comparable property in the same geographic market may be as much as a year old.
Appraisers must have a solid grasp of the direction prices are going, so that they can appraise the value of a property based on the most recent comparable sales they can find.
“The primary challenge is keep-ing up with the market,” says Bowyer.
For Class B and C properties, prices have fallen as fewer buyers have come out to bid. Some $6.65 billion in seniors housing transactions closed in the first half of this year compared with $8.2 billion during the same period in 2015, a drop of 23 percent, says CBRE.
REITs have dramatically reduced their purchases of seniors housing assets. “Previously, the REITs were ultracompetitive on large portfolios, and in order to win these portfolios they tended to not differentiate too much between urban and secondary locations, and even between Class A and Class B assets,” says Bissell.
REITs often state that they are seeking only Class A assets, but in practice they have and will purchase Class B properties. “They remain very active but have become a bit more discerning,” says Bissell.
The publicly traded REITs may now be in a better position as their stock prices recover and low interest rates continue. “That could allow prices for Class B and Class C product to hold, if not show some improvement as we move through the end of 2016 and into 2017,” says Bowyer.
As REITs step back, buyers such as pension funds and private equity funds help fill the void. “Large fund managers are committing more resources as new institutional investors come to this space who, as recently as five years ago, had no interest in seniors housing.”
The remaining investors like pension funds are buying more carefully. “Now these buyers tend to be more focused on quality and location,” says Bissell.
New construction worries
Appraisers also need to worry about trends in property fundamentals. That’s especially true in times like today, when many experts worry about overbuilding.
“It’s not a question of if we have oversupply. It’s a question of when,” says Alan Plush, CEO of HealthTrust, based in Sarasota, Fla.
The occupancy rate of seniors housing apartments in the top 31 markets was 89.8 percent on average in the second quarter, including independent living, assisted living and memory care, according to NIC. That’s down 10 basis points from year-earlier levels but equal to its three-year average.
“A healthy occupancy rate averages around the low 90s,” says Beth Mace, chief economist for NIC. “The basic trends are solid, though there are certain markets that are going to go through some dislocation as new properties come on line.”
A large number of new projects are under construction. “In many submarkets there may be four, five, or six other facilities under construction,” says Bissell. “It wouldn’t surprise me to see some distress.”
For example, the occupancy rate for seniors housing properties in the Atlanta metro area averaged 87.6 percent occupied in the third quarter. But the number of new projects planned for the metro area equals 12.9 percent of the existing inventory, according to NIC.
“People keep trying to put projects into these markets,” says Bissell. “That’s surprising.”
Appraisers are often called on to provide forecasts of the likely value of planned new developments or value-added investments. “Some new properties are falling short of the expectations that were modeled,” says Bissell.
Developers often now assume their planned projects will lease up as well as — or better than — properties that opened a year or two ago. According to appraisers, developers often anticipate occupancies and rents that are too high and expenses that are too low.
“They are pushing to make the deals pencil out,” says Bissell. “We sometimes see pro forma estimates that are a little unrealistic.”
Developers may have grown complacent over the past few years as a result of strong demand from retirees who helped fill up many new properties.
“The first round of new construction did well. The second round did okay. Now the third round of new construction has some marginal projects in the pipeline,” says Plush.
Will purse strings tighten?
Construction lenders are growing more cautious because of concerns about overbuilding, says Plush. However, many dubious projects are still finding the financing to start construction.
“Community and regional banks are stepping into some of these projects that a more experienced lender would say ‘no’ to,” says Plush.
Developers are often surprised by the results of the market studies they ask appraisers to complete. “One developer thought it had found a place where no one else was looking to build. It turned out three new projects were coming,” says Plush. “It’s getting harder to find those niches that haven’t been exploited.”
Appraisers also carefully consider the experience of the developer and operator when they assess whether a property will succeed.
The latest round of development also includes more properties built by inexperienced seniors housing developers who are partnered with inexperienced operators.
“It’s very hard to find good operators,” says Plush. “Everyone is so busy.”
The construction budget for a development can also help reveal the competence of a development team. “I also look for a construction budget that is well thought out,” says Plush.
Value-added appraisal challenge
Appraisers are also increasingly likely to be hired to evaluate plans to buy and improve the operations at existing seniors housing properties.
“Those are the most challenging assignments,” says Plush. More investors are buying these “value-added” developments, which fit neatly into the strategies of private equity funds that are becoming more dominant as buyers of seniors housing.
Appraisers look carefully and skeptically at the stabilized occupancy projected for the building, the rents it is likely to generate and the anticipated operating margins.
“We see many developers, often the less experienced, forecasting unreasonably low expense margins,” says Bissell. “In many cases when we are asked to appraise these buildings several years down the road, we find that the developers’ expense forecasts were not met.”
A fully renovated building that is 30 or 40 years old will still require more capital expenditures over time than a new building. “In older buildings, things break,” says Plush.
Even after a major renovation, an older building may still be less competitive in the marketplace than a new building. Some features of older buildings are typically impossible to update, like the size of the dining rooms or individual bedrooms or the height of the ceilings.
As construction costs and property prices increase, rents may not increase enough to support the renovation. “We are at a time in the cycle where construction costs are at an all-time high,” says Bowyer. “Feasibility is a big focus for a value-added deal.”
The hard cost of a renovation might simply be higher than the likely increased value due to higher rents.
To really assess a plan to add value to a community, appraisers ask lot of questions.
“We just have to get the whole story,” says Tim Baker, managing partner for Principal Valuation. “We want to understand how value-added developers plan to operate the community, trim expenses and raise revenue. It has got to be reasonable.”